And if you read it, the basic message is: Yeah, we have some
options, and none of them is likely to work very well.

In the following section, he highlights three key possibilities,
and in each case he makes a very good point why they might not
work.

The bottom line: If youre hopes for a recovery hinge on the Fed,
you should rethink that.

A first option for providing additional monetary accommodation,
if necessary, is to expand the Federal Reserve's holdings of
longer-term securities. As I noted earlier, the evidence suggests
that the Fed's earlier program of purchases was effective in
bringing down term premiums and lowering the costs of borrowing
in a number of private credit markets. I regard the program
(which was significantly expanded in March 2009) as having made
an important contribution to the economic stabilization and
recovery that began in the spring of 2009. Likewise, the FOMC's
recent decision to stabilize the Federal Reserve's securities
holdings should promote financial conditions supportive of
recovery.

I believe that additional purchases of longer-term securities,
should the FOMC choose to undertake them, would be effective in
further easing financial conditions. However, the expected
benefits of additional stimulus from further expanding the Fed's
balance sheet would have to be weighed against potential risks
and costs. One risk of further balance sheet expansion arises
from the fact that, lacking much experience with this option, we
do not have very precise knowledge of the quantitative effect of
changes in our holdings on financial conditions. In particular,
the impact of securities purchases may depend to some extent on
the state of financial markets and the economy; for example, such
purchases seem likely to have their largest effects during
periods of economic and financial stress, when markets are less
liquid and term premiums are unusually high. The possibility that
securities purchases would be most effective at times when they
are most needed can be viewed as a positive feature of this tool.
However, uncertainty about the quantitative effect of securities
purchases increases the difficulty of calibrating and
communicating policy responses.

Another concern associated with additional securities purchases
is that substantial further expansions of the balance sheet could
reduce public confidence in the Fed's ability to execute a smooth
exit from its accommodative policies at the appropriate time.
Even if unjustified, such a reduction in confidence might lead to
an undesired increase in inflation expectations. (Of course, if
inflation expectations were too low, or even negative, an
increase in inflation expectations could become a benefit.) To
mitigate this concern, the Federal Reserve has expended
considerable effort in developing a suite of tools to ensure that
the exit from highly accommodative policies can be smoothly
accomplished when appropriate, and FOMC participants have spoken
publicly about these tools on numerous occasions. Indeed, by
providing maximum clarity to the public about the methods by
which the FOMC will exit its highly accommodative policy
stance--and thereby helping to anchor inflation expectations--the
Committee increases its own flexibility to use securities
purchases to provide additional accommodation, should conditions
warrant.

A second policy option for the FOMC would be to ease financial
conditions through its communication, for example, by modifying
its post-meeting statement. As I noted, the statement currently
reflects the FOMC's anticipation that exceptionally low rates
will be warranted "for an extended period," contingent on
economic conditions. A step the Committee could consider, if
conditions called for it, would be to modify the language in the
statement to communicate to investors that it anticipates keeping
the target for the federal funds rate low for a longer period
than is currently priced in markets. Such a change would
presumably lower longer-term rates by an amount related to the
revision in policy expectations.

Central banks around the world have used a variety of methods to
provide future guidance on rates. For example, in April 2009, the
Bank of Canada committed to maintain a low policy rate until a
specific time, namely, the end of the second quarter of 2010,
conditional on the inflation outlook.4Although this approach seemed to work well in Canada,
committing to keep the policy rate fixed for a specific period
carries the risk that market participants may not fully
appreciate that any such commitment must ultimately be
conditional on how the economy evolves (as the Bank of Canada was
careful to state). An alternative communication strategy is for
the central bank to explicitly tie its future actions to specific
developments in the economy. For example, in March 2001, the Bank
of Japan committed to maintaining its policy rate at zero until
Japanese consumer prices stabilized or exhibited a year-on-year
increase. A potential drawback of using the FOMC's post-meeting
statement to influence market expectations is that, at least
without a more comprehensive framework in place, it may be
difficult to convey the Committee's policy intentions with
sufficient precision and conditionality. The Committee will
continue to actively review its communication strategy, with the
goal of communicating its outlook and policy intentions as
clearly as possible.

A third option for further monetary policy easing is to lower the
rate of interest that the Fed pays banks on the reserves they
hold with the Federal Reserve System. Inside the Fed this rate is
known as the IOER rate, the "interest on excess reserves" rate.
The IOER rate, currently set at 25 basis points, could be reduced
to, say, 10 basis points or even to zero. On the margin, a
reduction in the IOER rate would provide banks with an incentive
to increase their lending to nonfinancial borrowers or to
participants in short-term money markets, reducing short-term
interest rates further and possibly leading to some expansion in
money and credit aggregates. However, under current
circumstances, the effect of reducing the IOER rate on financial
conditions in isolation would likely be relatively small. The
federal funds rate is currently averaging between 15 and 20 basis
points and would almost certainly remain positive after the
reduction in the IOER rate. Cutting the IOER rate even to zero
would be unlikely therefore to reduce the federal funds rate by
more than 10 to 15 basis points. The effect on longer-term rates
would probably be even less, although that effect would depend in
part on the signal that market participants took from the action
about the likely future course of policy. Moreover, such an
action could disrupt some key financial markets and institutions.
Importantly for the Fed's purposes, a further reduction in very
short-term interest rates could lead short-term money markets
such as the federal funds market to become much less liquid, as
near-zero returns might induce many participants and
market-makers to exit. In normal times the Fed relies heavily on
a well-functioning federal funds market to implement monetary
policy, so we would want to be careful not to do permanent damage
to that market.

A rather different type of policy option, which has been proposed
by a number of economists, would have the Committee increase its
medium-term inflation goals above levels consistent with price
stability. I see no support for this option on the FOMC.
Conceivably, such a step might make sense in a situation in which
a prolonged period of deflation had greatly weakened the
confidence of the public in the ability of the central bank to
achieve price stability, so that drastic measures were required
to shift expectations. Also, in such a situation, higher
inflation for a time, by compensating for the prior period of
deflation, could help return the price level to what was expected
by people who signed long-term contracts, such as debt contracts,
before the deflation began.